What you need to know about the debt ceiling

Eileen Ambrose, The Baltimore Sun

Until recently, the markets largely ignored the political jockeying over whether to raise the federal debt ceiling, figuring there's no way Congress would purposely default on the nation's obligations and potentially throw the U.S. economy into another recession.

But as the Oct. 17th deadline approaches with no resolution in sight, markets are getting nervous.

Rates on Treasury bills have been rising. The Dow Jones industrial average gave up 296 points, or nearly 2 percent, early this week, but rose slightly Wednesday with the nomination of Janet Yellen to lead the Federal Reserve.

Wall Street and corporate CEOs are speaking out against using the debt ceiling as a ploy to score political concessions.

"It ought to be banned as a weapon," billionaire investor Warren Buffett told Fortune. "It should be like nuclear bombs, basically too horrible to use."

The debt ceiling has been part of this country's financial management for nearly a century. For years, it was lifted without much debate, but critics sometimes used the occasion to complain about the nation's spending. Only in the past few years have some seriously threatened not to raise the limit as a political bargaining chip.

As the countdown to default continues, here's what you need to know:

What is the debt ceiling?

For years, the federal government has spent more than it takes in from taxes. To cover this annual shortfall, Uncle Sam raises money through the sale of Treasury bonds. The accumulation of these budget deficits year after year is the national debt.

Congress has set a limit — the debt ceiling — on how much the government may borrow since 1917. Before then, lawmakers had to approve each time the government issued bonds. With the onset of World War I and paying for it, the debt ceiling was created to give the Treasury more flexibility in managing finances, according to the Congressional Research Service.

The debt ceiling is now $16.7 trillion. That limit was reached in May, but the Treasury Department took what it calls "extraordinary measures" to keep up with the nation's bills.

But those maneuvers will be exhausted by Oct. 17th, by which time the government will have only $30 billion on hand to pay expenses that can be as high as $60 billion on certain days, Treasury Secretary Jack Lew told Congress in a letter this month.

"If we have insufficient cash on hand, it would be impossible for the United States of America to meet all of its obligations for the first time in our history," Lew said.

How high must the ceiling be raised?

That depends on lawmakers. If Congress wants to postpone another debt ceiling showdown until the end of next year — after the November elections — the debt limit would have to be raised by about $1.1 trillion, said Loren Adler, research director for the nonpartisan nonprofit Committee for a Responsible Federal Budget.

How many times has the debt ceiling been raised?

Almost 100 times, with some being short-term extensions while lawmakers negotiate bigger budget compromises. In 1990, for instance, the debt ceiling was temporarily raised six times before lawmakers agreed on a deficit-reduction bill along with a permanent increase in the debt ceiling, Adler said.

Does raising the debt ceiling increase spending?

No. Raising the debt ceiling only allows Uncle Sam to borrow the money needed to pay its obligations that Congress has already approved.

Not raising the ceiling is "like going into a restaurant and ordering a meal and then at the end saying you're not going to pay for it," said Curt Grimm, a professor of economics and strategy at the University of Maryland, College Park.

The time to trim the bill for dinner is when you order. Similarly, if politicians want to make a stand against spending, the time to do so was when they authorized the expenditures.

Has the U.S. ever defaulted before?

Some academics and budget experts argue that we have had defaults before — although certainly nowhere near the scale of what could happen next week.

In 1790, for instance, the newly formed U.S. government agreed to take on the war debt racked up by states and deferred interest payments on those bonds for a decade. In 1933, Congress — at President Franklin D. Roosevelt's urging — changed the law so investors holding bonds that funded World War I could no longer demand repayment in gold.

And in 1979, the Treasury Department, dealing with processing glitches and a surge in demand for Treasury bills, was late with $122 million in payments to investors.

What happens if the debt ceiling isn't raised?

The government would not be able to borrow more and would be forced to rely on whatever taxes and fees come in to pay its ongoing bills. Under this scenario, the government would not be able to pay nearly one-third of its obligations between Oct. 18 and Nov. 15, the Bipartisan Policy Center calculates.

"It's unclear what would happen," said Till Schreiber, an assistant professor of economics at the College of William & Mary in Williamsburg, Va. While smaller, financially strapped countries have defaulted, we have never seen the foremost economy in the world unwilling to pay its bills, he said.

Most agree that the outcome would be bad — worse than the fallout from the Lehman Brothers collapse five years ago.

"The government could stop making interest payments to its bondholders. This means investors, like large Wall Street firms, would find their income stream slowed, leading them to reduce the amount of credit they supply," Aaron Pacitti, an assistant professor of economics at Siena College in New York, wrote in an email.

"Given the massive size of the U.S. debt market, this could lead to a credit crisis, where banks stop lending, causing credit markets to freeze. Businesses wouldn't be able to borrow to meet payroll or pay bills, so there'd be massive layoffs, sending an already fragile economy back into a recession," he said.

Payments also might be reduced or stopped to veterans, Social Security recipients, the unemployed and families receiving food assistance, Pacitti said.

"These are the most vulnerable groups in society who would be cast deeper into poverty," he said.

Lastly, Pacitti said, "a default would also make the U.S. look like a third-world country, whose political system is spiraling into an abyss."

Could the government make some payments?

Some Republicans have suggested that if the debt ceiling isn't raised, the federal government could still make interest payments to bondholders to avoid defaulting on U.S. debt.

But that could disrupt markets and lead to higher borrowing costs.

Bondholders would rightly wonder if they might be the next not to be paid, said Marc Goldwein, senior policy director at the Committee for a Responsible Federal Budget.

It also might not be easy — or even possible — to pick and choose who gets paid. Many expect that the Treasury would prioritize payments, but Adler said there is a constitutional question of whether it could do so because only Congress is supposed to determine spending.

And it would be nearly impossible to reconfigure the government's computer system that automatically makes 3 million payments a day, he added.

Lawyers might benefit, though. Everyone legally entitled to a payment could sue the government for damages, Adler said.

Is a brief default OK?

Another theory offered up by some Republicans is that a default of a day or so would have little impact.

But once the country breaches its promise to pay its obligations, you can't undo that. And it's likely that investors and consumers would fear it could happen again.

"There would be chaos in terms of loss of faith in the United States and its creditworthiness ... and loss of faith in our political system," Grimm said.

Do we need a debt ceiling?

Goldwein said the debt ceiling serves as a reminder of the debt we are accumulating.

But economists note that only one other industrialized nation, Denmark, has a debt ceiling. The debt ceiling, some economists say, is an anachronism and should be abolished.

"It doesn't have any purpose" because the decisions of how much to spend are made when lawmakers vote on legislation, said Robert Barbera, co-director of the Center for Financial Economics at the Johns Hopkins University.

The debt ceiling is being used to fight budget battles all over again, he said.